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Quarterly Letter to Clients

January, 2014

Indices at quarter-end (December 31, 2013):

Dow Jones Industrials: 16,576.66 4Q'13 +9.56% YTD +26.50%

Standard & Poor's 500: 1,848.36 4Q'13 +9.90% YTD +29.61%

It has been a wonderful year for stocks, a year of records. There seems to be a general feeling (or fear) that when we have such a tremendous year the following year will be negative. This is not supported by history, though. I recently had an exchange with a friend on this subject, which led me to look up the numbers.

We were talking specifically about years in which the averages rose by 20% or more. Over the 26 full years since I opened shop in 1988 (arguably a complete market cycle), the Dow Jones Industrial Average rose 20% or more 7 times: 1989; 1991; 1995; 1996; 1997; 1999; and 2003.

(Of course, 2013 was the eighth 20%-plus year, but since we don't know what 2014 holds, we will not include it in this discussion.)

Of those seven great years, the market rose five times the following year and declined only twice.

Two other years saw large gains that did not quite make the 20% bar: the DJIA was up 16% in 1998 and 18.8% in 2009, and in both cases rose again the next year. So the nine biggest years of the last quarter-century were followed seven times by a further advance, falling only twice.

Thus we see that a robust market year is most often followed by another gain. Apparently, the factors that push the market higher do not end on any given December 31.

You can't just talk about the great years without looking at the negative years. Over that same 26 year period, the market was down six times, with three of those back-to-back: 2000-2001-2002. Only one year fell more than 20%, that being 2008, when we dropped 34%.

The average drop, including that whopper, was 11.5% (without it, 7%). But here again, the years following a drop seem to be more up than down: after those six declines four times the subsequent years were positive and only twice were they negative.

Stated another way: overall in that 26 year span we have had 20 plus years and only 6 down years. The average annual gain was 9.3%. Roughly one year in four was plus 20% or more, and one year in four was negative.

I had to ask myself if that last quarter-century-plus was an unusual period, perhaps driven by technological gains, or other advances of a constantly modernizing world. So I expanded my range to the 60 years from 1954 to 2013, and it turns out not to be an anomaly. Over the last 6 decades the pattern holds: Fifteen times in those 60 years the average gained 20% or more; 15 times it declined. It seems the odds of a gain of 20% or more are one in four, and the odds of a decline of any size is also one in four. (Can we count on this? No. But it's always good to know the odds.)

When the market went up, it gained an average of 11.3%, and when it went down, it fell a little over 12%. Combined, the average annual gain over those 60 years was 8.28%.

There were 4 instances of five or more consecutive up years: 1954-59; 1985-89; 1991-99; and the current period, 2009-13. Compare that to only two instances in sixty years of back-to-back declines, the two years of 1973-74 and the three years of 2000-2002.

This bolsters two of my ingrained feelings: first that you basically want to always be invested, and second, that buying in negative years is a very good strategy. The worse the year, the better the buying opportunity. Easy to say, hard to accomplish.

As for my bond clients, 2013 saw only marginal gains in the face of a negative bond market. Over the next few years, as rates continue to rise, we can expect more of the same. Our bond holdings, though, are of relatively short maturities, which is one reason that we have done as well as we have. So eventually, as rates rise and our current holdings mature, we should be able to invest in higher yielding paper, and thereby increase our cash flow and capture more amenable returns. A welcome prospect of all of us who depend upon our portfolios for our income.

So what does one do right now, after stocks have run so far and bonds seem poised to stagnate? In either strategy, stocks or bonds, we must remember that this is a marathon, not a sprint. Patience and prudence are the factors that make for success in investing. It is hard for me to be a buyer of stocks when they have run up so much, and harder still for me to buy bonds in the face of rising rates. But we have been in these situations before, and we will wait for our opportunities, which always come along.

I wish you a happy, healthy and prosperous new year.

Jim Pappas